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Beware of our susceptibility to narrative economics

For decades now, behavioural scientists have been telling us (to little effect) that people do not act rationally. Experiment after experiment finds – particularly when it comes to financial decisions – people rarely make the wise choice.

We tend as a species to concentrate on the short term, and put off thinking about the medium or longer term. It has spawned the new-fangled study of behavioural economics, which in turn is starting to influence how governments devise economic policy (such as compulsory enrolment in pension schemes, with an opt out – knowing full well that the inertia effect is one of the most powerful drivers in economic decision making).

Michael Lewis’ book "The Undoing Project" is stuffed full of examples from the pioneering work of Daniel Kahneman and Amos Tversky and how they profoundly changed thinking in a whole range of fields, from big data, to medicine, sports management and finance.

Robert Shiller, Nobel prize winning economist at Yale University, has a new book coming out soon, in which he says we have to move on from the economic assumption that people act rationally. He is trying to pitch a new way of looking at the world called "narrative economics", suggesting again that economists place more emphasis on the way human beings actually think.

This may help us overcome the "narrative fallacy", in which we as a species tend to take disparate bits of information and turn them into a narrative – because it’s easier for us to make sense of things that way.

Human wisdom has been distilled into narrative form to pass on hard earned lessons through myths, legends, bible stories, bedtime stories etc. There is even a narrative warning about the dangers of fake news (the boy who cried wolf). The problems with narratives, as Nassim Nicholas Taleb reminded us in "The Black Swan" is that they work fine up until the point that new information renders them useless.

This week another world class economist, the Governor of the Central Bank Philip Lane, made a rare public speech in which he too reminded us of our susceptibility to narrative economics. The key messages have been lost in the media concentration on the short term elements of his speech, namely property prices and mortgage issues.

These affect a fairly narrow section of society (prospective buyers of property and people who sell property ads in the newspapers, to name but two).

His upfront message was about the need to build resilience across the economy. Rather than trying to second guess how things are going to pan out, the Governor thinks policy should aim at making sure the system – and society – can withstand a range of shocks. A key part of that is to try and ensure that when a shock hits, the government does not have to act in a pro-cyclical way, as was the case in the great recession and financial crisis.

Then spending had to be cut and taxes increased to try and stop a meltdown in the public finances turning into a social catastrophe. Textbooks and commentators said the government should have stimulated the economy instead of going for austerity. But it was so boxed in that it had no realistic alternative.

Since then there has been what the OECD told us this week the strongest recovery seen in the 31 country block of most developed industrialized economies. The Eurozone is also enjoying its strongest growth in well over a decade. And the global economy is powering ahead, after its 2016 wobble, driven by strong trade growth.

But Governor Lane reminded us that things won’t keep going like this. Sooner or later there will be a reversal, or worse, somewhere in the constellation of economic events. That’s why the threat of a trade war from the Trump steel tariffs is so unsettling.

The Governor’s speech stressed "tail risk" threat to the current benign conditions facing the Irish economy and society. These include a reversal of the benign conditions in global financial markets, a stalling of reforms of the Euro area (such as banking union and capital markets union) re-opening the tensions of 2011-2012.

The impact of tax policy changes in the US and Europe on the location decisions of US multinational companies. And the dollar Euro exchange rate – and how it affects those locational decisions (and the interplay between the exchange rate and the tax policy changes). And that’s without mentioning Brexit.

Any of all of these tails risks – low probability, high impact events - might come to pass. How will our system cope if they do? Do we have the fiscal firepower to cope? Have we done enough to reduce debt so we can ramp up borrowings again if we need to? Is the tax base wide enough? How strong are the public and private finances? Really?

Faced with a property obsessed media and country, let me give in and offer a narrative image that might make this message easier to digest. Rather than trying to rebuild our finances in the image of a Celtic Tiger "McMansion", all flat screen giant TV’s, hot tubs and faux-Hamptons décor, we need to think about a castle.

A big, solid medieval crusader castle. There is a reason why rich people built castles: they were for the protection of wealth, not its ostentatious display. Withstanding unpleasant assaults is always easier within solid walls and ramparts.

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